Young Canadians are taking on such high levels of debt to finance their home purchases that a sudden market correction would leave many of them in big trouble, according to a recent study from Canadian Centre for Policy Alternatives.
Policymakers have been warning for years about the dangers of escalating house prices and the debt loads that come with them. Most agree that the Canadian housing market is overheated: The debate is largely over the trajectory of any coming adjustment.
But the CCPA report, entitled The Young and the Leveraged, is the first to document how such a drop could impact younger families, who typically have only a small amount of equity in the homes they’ve borrowed so much to own.
Also read: Stuck in the Starter Home>
Younger Homeowners At Greater Risk
“Declines in real estate prices would have a strongly disproportional impact on young homeowners,” says CCPA economist David Macdonald. “If, or more likely when, real estate prices fall, families in their 20s and 30s can expect to lose a substantial portion of their net worth, and could find themselves owing more than their house and other assets are worth.”
He suggests that a 20 per cent decline in home prices would leave tens of thousands of young families “underwater,” strapped with mortgages actually greater the value of their house – so much so that the net worth of homeowners in their 20s and 30s could drop by 45 per cent and 39 per cent respectively, he cautions.
No big deal? Well, just ask those who got caught in the housing bust across the border. In retrospect, most Americans who bought homes in the past several years would have been better off renting.
Leverage Has A Multiplying Effect
Housing corrections tend to have a multiplying effect on household finances because of the large amounts of leverage involved in buying a home. As a rule of thumb, every 10 per cent decline in house prices represents a loss of 20 per cent on the average person’s net worth, CCPA estimates.
But net worth is just a number. The real test is when interest rates start to rise and borrowers with oversized loans relative to income start to see their finances stretched. The average debt-to-income ratio among thirtysomethings has almost doubled since 1999, hitting a new high of 4:1, the highest of any age group.
While indicators suggest a gradual rise in interest rates would be comfortably absorbed by most homeowners (supporting the “soft landing” scenario Carolyn Wilkins, the Bank of Canada’s number-two policy, says we’re headed for) you have to decide what all this means for you.
Could You Be In Over Your Head?
Making money so cheap has clearly enticed some people into buying more house than they can really afford. Do you think you might be one of them?
The good news is that, even if house prices drop, you’re not directly affected until your mortgage comes up for renewal. But it still pays to run the numbers. If you have a $400,000 mortgage and the value of your house is only 375,000, for example, you’re going to have to come up with the difference.
How much of a problem is this going to be? Do you have other assets? Are they fairly liquid? What are the tax implications of tapping them?
Are you sure you can count on mom and dad? According to the Bank of Montreal’s most recent Home Buyer’s Report, 42 per cent of current homeowners say they’re already relying on financial assistance from relatives to help them out. Ask your parents how they feel about stepping up again.
No, You Can’t Simply Walk Away
Bailing out of a mortgage in a worst-case scenario may seem appealing – but the consequences for doing so are steep.
Your credit will plummet, making it tougher to buy anything from a rental apartment to car insurance. You’ll also be stonewalled by the mortgage industry in the future.
Before you even think of walking out the door, talk with your mortgage provider. Lenders don’t want you to default on your loan any more than you want to wreck your credit. They’ll work with you, but you should do your homework first to see if you really are at risk.